Copyright Reminder

The commentaries that appear at TSI may not be distributed, in full or in part, without our written permission. In particular, please note that the posting of extracts from TSI commentaries at other web sites or providing links to TSI commentaries at other web sites (for example, at discussion boards) without our written permission is prohibited.

We reserve the right to immediately terminate the subscription of any TSI subscriber who distributes the TSI commentaries without our written permission.

Forecasting

January is generally perceived to be some sort of 'starting point' for the markets and many investors measure their performance on a calendar-year basis. However, market trends don't start or stop simply because one year ends and the next one begins, so in that respect there is nothing especially significant about January as far as forecasting is concerned. And forecasting is, itself, a generally over-rated art. For instance, the accuracy of any 12-month forecasts we make at the start of a year or at any other time should have little bearing on how much money we end up making over that 12-month period. Instead, the amount of money we make will mostly be determined by how well we analyse the new evidence that is continually becoming available and adjust our positions in accordance with this new evidence. After all, even when you start off on the right track the markets have a way of throwing you enough curve balls over any 6-12 month period to shake your conviction and, perhaps, cause you to change your strategy and blow any advantage you might have originally had. On the other hand, having started off on the wrong track you might recognise that things aren't falling into place as you originally expected and make some appropriate and timely adjustments to your strategy. In other words, real-time analysis has a far greater effect on our performance than any forecasts we might concoct at the start of a year (or at any other time). 

When we analyse the markets a result is that we arrive at expectations of what will happen in the future. These expectations can, in turn, be presented as forecasts. The way we think of forecasts, though, is as starting points that are subject to constant review, and possibly change, as more evidence becomes available. They are never fixed in stone and, as discussed above, they don't -- or, at least, shouldn't -- determine how much money we end up making.

As far as financial-newsletter writers are concerned a correct forecast offers the benefit of 'bragging rights'. For example, a forecast that proves to be correct can be used to promote the newsletter with the aim of drawing-in more subscribers. It should be noted, though, that anyone who makes a lot of forecasts over a long period of time will end up with a lot of correct forecasts as a result of chance alone, so by cherry-picking the ones that proved to be correct it would be possible for almost anyone to promote themselves as being a great forecaster. 

Cherry-picking the good forecasts is just one of many tricks used by newsletter writers to portray themselves as great forecasters. Another is to word forecasts in such a way that the forecast will appear to be right regardless of what actually transpires (for example, the classic "if the market moves above price-level 'A' it will move higher but if it moves below price-level 'B' it will move lower"). 

We are not trying to denigrate the newsletter-writing industry. We are, after all, part of that industry. Furthermore, because the newsletters that are 100% supported by their subscribers (the ones that don't rely on any advertising revenue or payment from anyone other than their subscribers) provide independent analysis they can be the best source of information for investors. What people should understand, though, is that notwithstanding the promotional efforts of some newsletter-writers genuine forecasting accuracy over a long period of time is not achievable. What is achievable is accurate risk-versus-reward analysis. 

As far as this year is concerned, our 'starting points' for some of the markets we follow can be summarised as follows:

 - The stock market will roll over during the first half of 2004 and embark on a large decline lasting at least 12 months. Recent price action has, however, muddied the waters as to whether a major peak will occur very early in the year or following some additional upside over the coming months.

 - Bonds will move substantially lower over the next 12-18 months, but we are fuzzy on whether a major decline will begin almost immediately or following a few more months of consolidation.

 - Gold and the US$ will reach intermediate-term extremes during the first half of this year, most likely at around 460 for the gold price and 80 for the Dollar Index. Lengthy (6 months or longer) corrections will then occur.

We have good reason to expect that the above forecasts will prove to be close to the mark because they've been arrived at following a careful weighing of the fundamental, technical and sentiment evidence. More importantly, though, based on our past performance we have good reason to expect that we will make money this year regardless of how well these initial forecasts pan out.

The Money Supply Mystery

When long-term interest rates bottomed in June of 2003 and then moved sharply higher, mortgage-refinancing activity slowed dramatically. Since mortgage refinancing has been the main engine of money-supply growth in the US over the past 8 years the sharp decline in mortgage refinancing resulted in a sharp decline in the money-supply growth rate. There is no mystery here. 

Substantial changes in the year-over-year money-supply growth rate have tended to impact the economy with a lag of at least two quarters, so the economy should not be expected to show significant weakness in response to the recent downturn in money-supply growth until the second quarter of this year. Once again, there is no mystery here.

Where the mystery does lie is in the fact that the pace of mortgage refinancing has continued to slow over the past 4 months despite a moderate decline in long-term interest rates. This is a mystery in the sense that it is a pronounced divergence from what has tended to happen over the past few years. What does it mean? Probably that most people who could be enticed to refinance their home have already done so and that new lows in long-term interest rates (new highs in bond prices) will be necessary in order generate a substantial increase in mortgage refinancing activity and money-supply growth.

The US Stock Market

The Big Picture

In the latest Weekly Update we changed our 'big picture view' for the US stock market; we went from forecasting a drop to a major bottom (well below the October-2002 low) in 2004 to forecasting a test of the October-2002 low during 2005. In an attempt to explain this change we are going to use the below long-term chart of Japan's Nikkei225 Index.

There are so many important differences between Japan in the 1990s and the US today that using the performance of the Nikkei as a model for the US market would seem to be inappropriate to say the least. Furthermore, 4 years after its major peak the US market is clearly a lot stronger than was the Japanese stock market at an equivalent distance from its own major peak. There is, however, one very important market-moving similarity between post-bubble Japan and the current situation in the US (note that we can't refer to the current US situation as being "post-bubble" because the US credit bubble is much bigger now than it was 4 years ago). That similarity is the aggressive attempts of policy-makers to prevent the stock market from falling to a genuine bottom. In Japan these attempts revolved around massive deficit-spending and direct intervention in the stock market, while policy-makers in the US have used massive deficit-spending combined with tax cuts, war, and enormous monetary stimulus. Obviously, if the goal was to boost asset prices then US policy-makers have out-performed their Japanese counterparts.

The first major decline of the Nikkei's long-term bear market ended during the 3rd quarter of 1992 at point A on the above chart. The Nikkei then rallied into the 4th quarter of 1993 (point B), experienced a short and sharp pullback to point C, rallied to a new recovery high (point D), and then declined for about 12 months to the vicinity of its 1992 bottom (point E). Our contention is that it was government meddling that prevented the Japanese market from plunging well below its 1992 low during 1995 (point E) and throughout the remainder of the 1990s. This meddling, in its various forms, only had the long-term effect of delaying the collapse, but it does show that postponement is possible. And given what the US Administration and the Fed have already done in the name of propping up the stock market and giving the economy a short-term boost we are wondering whether a multi-year period of range-trading might lie in front of the US stock market. This is why our revised 'big picture view' mentions a test of the 2002 low during 2005 rather than a drop to a new low. Whether or not there is a drop to a new low during 2005 could, we think, be determined by the amount of government-sponsored market support that materialises at the time. 

After having already done so much to prop-up the stock market the question is: what else could the US government do? After all, a lot of the monetary fuel appears to have been spent and there are practical limits on deficit spending. One big card that is yet to be played by the US, though, involves the investment of Social Security money in the stock market. This idea was floated during the Clinton Administration and never received much support, but at that time there was no real political need to pass the required legislation. However, under more dire circumstances the political will needed to create such a change might exist. 

The below chart illustrates our current expectations for the S&P500 Index as far as the next two years are concerned. The red line on the chart represents the 'with intervention' scenario and the green line represents the 'without intervention' scenario. Also, because there is no technical evidence that the market is presently close to its ultimate recovery high the second of the peaks shown occurring in the first half of 2004 will probably be the higher of the two. The current situation in the US market could therefore be likened to point B on the above Nikkei chart, although we doubt that the coming pullback in the US market will be anywhere near as large as the Nikkei's B-C pullback in late 1993.

Current Market Situation

Below is a chart of the NDX/Dow ratio from the beginning of 2000 to the present day. We are including this chart to illustrate that every significant decline in the market over the past 4 years has been characterised by weakness in the NDX relative to the Dow while every significant rally has been characterised by strength in the NDX relative to the Dow. Furthermore, although the NDX/Dow ratio has tended to roll-over prior to important market peaks over the past few years there was one occasion -- March 2000 -- when the peak in NDX/Dow coincided with the peak in the market. In fact, NDX/Dow rocketed higher during the two months leading up to the major market peak in March of 2000. 

It is very unlikely that we will see the same frenetic activity in the tech and telecom stocks this year as we saw during the first quarter of 2000. Actually, it is probably going to be decades before another tech-stock mania becomes possible. We therefore don't expect to see a sharp upward move in NDX/Dow just prior to this year's peak. Instead, it is much more likely that NDX/Dow will roll over before the Dow reaches its ultimate recovery high. 

In any case, regardless of whether an NDX/Dow peak precedes or coincides with the next major peak in the overall market, there is a high probability that the early stages of the next major decline will be characterised by pronounced weakness in the NDX relative to the Dow. By the same token, it will make sense to assume that any market decline that is not characterised be relative weakness in the NDX will turn out to be a correction within an on-going upward trend.

Based on the price action during much of November and December it appeared as though the market was heading for an important peak in January, but the performances of the stock indices since mid-December indicate that we are probably still a few months away from the ultimate peak. 

We expect that a sharp pullback will soon get underway, but the odds are now in favour of this pullback being followed by a rally to a new recovery high. Therefore, the USPIX position that we currently hold will probably be exited within the next month or so.

As far as the next 4-6 weeks are concerned, a reasonable downside target for the NDX is 1300 (see chart below). 1300 coincides with good support and a drop to this level would represent a retracing of slightly less than 50% of the gains achieved since the March-2003 bottom.

The way things are currently shaping up any pullback in the stock market over the next month will most likely occur in parallel with a rebound in the US$ and a drop in the bond market. This, in turn, might mean that the Dow Industrials Index drops by a greater percentage than the NASDAQ100 Index. To ensure that we are covered against this possibility we are going to add a position in Dow (DJX) put options to the Stocks List. Specifically, we'll add the DJX June-2004 $96 puts (DJVRR) to the Stocks List using yesterday's closing price of $1.50 for record purposes.

The chart pattern of the Biotech Index (BTK) continues to show considerable upside potential (see chart below). If the BTK drops back to around 450 we will seriously consider adding some BTK call options and/or a biotech fund to the Stocks List.

Gold and the Dollar

Gold Stocks

Newmont Mining (NYSE: NEM) has broken below the bottom of the price channel that has defined its trend since March of last year. A reasonable target for NEM over the next few weeks is support in the $37-$40 range.

A drop to $37 by NEM would represent a fall of about 17% from its current level and 26% from its December peak. If we apply the same percentages to the AMEX Gold BUGS Index (HUI) we arrive at a value of 190, which happens to correspond with a support level (see chart below). In other words, 190 looks like a reasonable downside target for the HUI over the next few weeks. 

Our expectation is that the current correction in the gold sector will be followed by a strong rally over the ensuing 4 months or so. However, we doubt that this year's highs in the popular gold-stock indices such as the HUI and the XAU will exceed last December's peaks by a wide margin. In fact, we wouldn't be surprised if the indices made lower highs. As discussed in previous commentaries, the stocks that are likely to move well above last year's highs over the next several months will mostly be the exploration/development-stage stocks as well as the majors that didn't really participate in last year's rally (for example, HMY, GFI, KGC).

Even if the HUI does move to a new high following the completion of the current correction, the recent breakdown in the HUI/S&P500 ratio (see chart below) indicates that it might have already peaked relative to the S&P500 Index. 

Current Market Situation

The below chart shows the current situation for the gold/GYX ratio (GYX is an index of industrial metals prices). We think gold has less short-term downside risk than the industrial metals, but the chart is beginning to take on a longer-term bearish appearance (bullish for the industrial metals relative to gold).

The 3-month gold interest rate is currently 0.07% (0.21% annualised), an absurdly low rate. In fact, no one in their right mind would make a commercial decision to lend their gold bullion for a 0.21% per year return unless earning an appropriate return wasn't their main reason for lending the gold. 

The lenders of gold bullion are the central banks and the only reason why central banks would lend gold at such low interest rates would be to put downward pressure on the gold price. The problem they face with this strategy is that when gold is in a bull market it makes no sense for anyone to borrow gold even if the interest rate is zero percent. This is because a 0% gold loan would only be attractive if there was good reason to be sure that the gold price was not going to rise by more than a few percent over the term of the loan. 

In any case, the central banks are obviously making an effort to cap the gold price, just as they have done for many decades and will no doubt continue to do for as long as the current monetary system remains in place. We don't, however, spend any time worrying about central bank intervention in the gold market because as long as the interest rate and currency market trends remain gold-bullish the interventionist efforts of the CBs are just 'noise'. For example, take a look at the below chart comparison of the HUI/gold ratio and the yield-spread (the yield on the 30-year bond divided by the yield on the 3-month bill). In spite of whatever attempts the CBs have made over the past few years to stem the tide, as soon as the yield-spread began trending higher in November of 2000 the trend for gold turned positive (as confirmed by an upturn in the HUI/gold ratio). 

As long as the yield-spread is trending higher there won't be much danger of anything other than normal corrections in the gold market. By the same token, anyone who thinks the gold price is going to keep trending higher after the Fed eventually moves to reduce the yield-spread (by forcing short-term rates higher relative to long-term rates) is living in a fantasy world. 

Below is a daily chart of February gold futures. A daily close below the 18-day moving average (currently at 418.50) would confirm that a correction was underway.

Update on Stock Selections

As per the e-mail sent to subscribers during the early hours of Wednesday morning (US time) we took a profit of 108% on North American Palladium and a loss of 9% on the Kinross Gold warrants (refer to http://www.speculative-investor.com/new/stockemail.asp for details)

Corvis Corp. (NASDAQ: CORV) would probably turn out to be a fine long-term investment, but we recommended the stock as a short-term trade at the end of last year because it was a likely candidate to do well during any "January effect" rally. At yesterday's closing price of $2.80 the stock has provided us with a nice gain of 73% in less than 3 weeks. More upside is possible in the short-term, but we are going to take our money off the table now.

There is still significant short-term downside risk in the gold sector. Therefore, although some good buying opportunities are already emerging we are going to wait until we see some evidence that the correction is over before suggesting any new gold stocks or reiterating buy recommendations on existing stock selections.

The Aflease stock price (Pink Sheets: AFKDY, JSE: AFL) has perked up over the past few days, most likely because the company's uranium assets are starting to get some attention. This stock should do extremely well once there is some certainty with regard to the company's up-coming financing.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/
http://bigcharts.marketwatch.com/